Another week, another wave of concern on American regional banks. Thankfully, the level of panic has eased slightly since the Federal Deposit Insurance Corporation appears to be backing the system, by precedent, if not by law. But the problem now is one of friction: Weak banks are losing deposits, watching funding costs rise as their lending to commercial real estate and risky companies tightens.
This means that more consolidation is looming. And while that’s welcome in the long run (since it’s crazy that America has more than 4,000 banks), this could create speed bumps in the short run.
However, as investors – and American politicians – look at them uneasily banksthere is also another sector that deserves our attention: life insurance.
In recent months, insurance has largely stayed out of the headlines. No wonder: these companies tend to be boring because they are supposed to hold long-term assets and liabilities. Logic suggests that they should win in a world of rising interest rates because they have large portfolios of long-term bonds that usually don’t need to mark the market, meaning they can reap income gains from rising rates without record losses.
However, their balance sheets are getting a little less predictable right now. And while that’s no cause for investors to panic, it does highlight a bigger problem: A decade of ultra-low rates has created distortions across the financial world, and it could take a long time to unwind. This attrition problem goes far beyond banks.
The issue at stake is captured in some graphs buried in the Federal Reserve recently released financial stability report. These show that insurance groups held approximately $2.25 billion of assets deemed risky and/or illiquid, including commercial real estate or business loans, at the end of 2021 (apparently the latest data available). In gross terms, it is almost double the level they held in 2008 and represents about a third of their assets.
This level of exposure is not unprecedented. Although the proportion of risky assets has increased in recent years as life insurance companies frantically search for yield in what was then a low-rate world, it was at similar levels shortly before the 2008 financial crisis.
But what is noteworthy is that there has also been a growing reliance on what the Fed considers “non-traditional liabilities – including securities backed by loan agreements, Federal Home Loan Bank advances and cash received through repurchase transactions.” term and securities lending”. And these deals often “provide some investors with the opportunity to withdraw funds on short notice.”
It is unclear how large this discrepancy is, as there are large gaps in the data, as noted by the IMF in its just recently relationship. For example, “exposures to illiquid private credit exposures such as secured loan obligations may mask the leverage embedded in these structured products.” Put simply, this means that insurance companies may be much more sensitive to credit losses than previously thought.
But the key point, notes the Fed, is that “over the past decade, the liquidity of life insurers’ assets has steadily declined and the liquidity of their liabilities has slowly increased.” This could potentially make it more difficult for life insurers to deal with any sudden increase in claims or even withdrawals.
Maybe that doesn’t matter. After all, insurance contracts are much stickier than bank deposits. And when the sector last experienced a shock, during the early Covid panic in 2020, it staved off a crisis by successfully (and quietly) orchestrating “a massive $63.5 billion surge” in liquidity, as separate Federal research Shows.
Fed analysts admit it’s not clear exactly how this liquidity surge occurred, since “legal filings are silent” on the details. But income from derivative transactions played a role, with the main source appearing to have been loans from the Federal Home Loan Bank system.
This is interesting, as it underscores another crucial issue that is often overlooked: it is the powerful quasi-state entity that is the FHLB that now underpins many parts of US finance rather than regional banks. Or to quote the Fed again: “Life insurers are becoming increasingly dependent on FHLB funding.” So much for American free market capitalism.
Such reliance also raises questions about the future, particularly if funding sources were to flee, or risky and illiquid assets deteriorate, or both. The latter seems very likely, given that higher rates are already hurting risky commercial real estate and business loans.
Again, I’m not suggesting this is a cause for panic; this is a slow moving saga. While a recent report from Barings shows that “a record 26% of life insurers were in a position to manage negative interest rates” at the end of 2022 (in other words, they had paper losses on bonds), these need not be realized unless companies go bankrupt.
But if nothing else, regulators clearly need better data and stringent asset-liability matching standards. And while the National Association of Insurance Commissioners of the United States apparently he is trying to implement this, for example by limiting insurers’ CLO holdings, will take time.
That’s why “today’s environment makes cash management so critical,” as Barings notes, particularly because “rising rates can be a contributing factor to insurer default.” In other words, it’s not just US regional banks that are at risk of becoming victims of today’s deflating credit bubble.
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